An historic marker beyond President Trump’s influence poses challenges for Wall Street.
In October, Wall Street’s bull market celebrated its two-year milestone, showing little indication of slowing down. Since the end of 2022, the timeless Dow Jones Industrial Average (^DJI 1.39%), the widely observed S&P 500 (^GSPC 1.59%), and the growth-oriented Nasdaq Composite (^IXIC 1.63%) have surged by 31%, 55%, and 82%, respectively.
This rally has been driven by various factors, including (but not limited to):
However, in the past four months, arguably the most significant influence on the Dow Jones, S&P 500, and Nasdaq Composite has been Donald Trump’s victory in November and his subsequent return to the presidency. During Trump’s initial term, the Dow, S&P 500, and Nasdaq skyrocketed by 57%, 70%, and 142%, respectively. To say that investors are eager for a repeat would be an understatement.
President Trump delivering remarks. Image source: Official White House Photo by Joyce N. Boghosian, courtesy of the National Archives.
The optimism surrounding Trump’s second term stems from the anticipation of tax cuts to the peak marginal corporate income tax rate and a push for deregulation. The former could lead to record share buybacks from S&P 500 companies, while the latter is expected to foster mergers and accelerate the introduction of innovations to the market.
While the conditions seem favorable for Wall Street’s continued growth, a historically reliable indicator, with over 150 years of back-tested data, suggests that the party may be coming to an end.
History indicates President Trump could preside over a substantial stock market decline
While the anticipated impact of tariffs and their effects on inflation has been an early worry for Trump’s second term, there’s a more pressing concern that has nothing to do with his various proposals.
The indicator signalling potential trouble for Wall Street is the Shiller price-to-earnings (P/E) Ratio for the S&P 500, also known as the cyclically adjusted P/E Ratio (CAPE Ratio).
To address the obvious, “value” is a somewhat subjective concept. Since individual investment goals and risk appetites vary, what one investor views as expensive might be a bargain to another.
Most investors rely on the traditional P/E ratio as a quick gauge to determine whether a stock (or the broader market) is seen as relatively cheap or pricey. This ratio, which divides a company’s share price by its trailing-12-month earnings per share (EPS), is effective for mature companies, but it can be less reliable for high-growth businesses and during recessions or shock events.
Conversely, the Shiller P/E Ratio utilizes inflation-adjusted EPS averaged over the previous 10 years. By incorporating a decade’s worth of EPS data, it reduces the likelihood of distortion from sudden events.
S&P 500 Shiller CAPE Ratio data by YCharts.
Although the S&P 500’s Shiller P/E only gained traction in the late 1990s, it has been back-tested to January 1871. In this 154-year span, the average multiple stands at 17.21. As of the market’s close on February 26, the Shiller P/E for the S&P 500 reached a staggering 37.55.
To illustrate the rarity of this figure, there have only been six occurrences since 1871, including the current instance, when the Shiller P/E has exceeded 30 for at least two months. Following each of the previous five occurrences, the Dow Jones Industrial Average, S&P 500, and/or Nasdaq Composite eventually experienced a decline ranging from 20% to 89%.
It’s important to highlight that the Shiller P/E is not a timing mechanism. In the past, a surge above a multiple of 30 led to significant downturns over a few months during the Great Depression, yet valuations remained elevated for over four years before the dot-com bubble burst. Although no pattern exists for when market corrections start, the Shiller P/E has maintained an impeccable record of predicting these eventual declines.
In today’s context—specifically since the commercialization of the internet and the rise of online trading three decades ago—the Shiller P/E has typically reached its lowest point during market downturns around 22. A decrease from the peak reading of 38.89 during the current bull market to approximately 22 would imply a 43% drop. Moreover, it would signify a crash of roughly 40% from the S&P 500’s all-time peak.
Without placing blame on him—this discussion would hold true even if Kamala Harris had won in November—President Donald Trump may oversee a valuation-driven 40% decline in stocks.
Image source: Getty Images.
Fortunately, stock market cycles are not linear
While the idea of a bear market or stock market crash may be unsettling for investors, perspective is crucial on Wall Street.
The reality is that market corrections, bear markets, and even crashes are a regular, healthy, and unavoidable aspect of the investment landscape. No amount of fiscal or monetary policy adjustments, or optimism from the investment community, can prevent downturns from occurring periodically.
What investors can cling to is the understanding that stock market boom-and-bust cycles are not linear.
Back in June 2023, analysts from Bespoke Investment Group shared a dataset on social media platform X, comparing the duration of every bull and bear market since the onset of the Great Depression in September 1929. This approximately 94-year analysis illustrated the stark contrast between downturns and periods of growth.
It’s official. A new bull market is confirmed.
The S&P 500 is now up 20% from its 10/12/22 closing low. The prior bear market saw the index fall 25.4% over 282 days.
Read more at https://t.co/H4p1RcpfIn. pic.twitter.com/tnRz1wdonp
— Bespoke (@bespokeinvest) June 8, 2023
On one hand, the average S&P 500 bear market lasts 286 calendar days, or about 9.5 months. On the other hand, the typical bull market for this index persists for 1,011 calendar days, or around two years and nine months—approximately 3.5 times longer than the average bear market.
Moreover, no bear market in the last 94 years extended beyond 630 calendar days. In contrast, 14 out of 27 S&P 500 bull markets, including the current one (if projected to the present), have endured for longer than 630 calendar days.
The ability for investors to adopt a broader perspective reveals that while downturns are normal and unavoidable, patience often pays off. According to a back-tested study by Crestmont Research, every rolling 20-year period for the S&P 500 since 1900 has yielded a positive total return, including dividends.
Regardless of whether President Trump’s second term sees another long bull market or enters a bear market, history makes one point clear: the Dow Jones, S&P 500, and Nasdaq Composite are likely to be significantly higher two decades from now.
